Tax planning for land preparation costs.

EXECUTIVE SUMMARY

* Land preparation costs with a limited useful life can be depreciated, provided they are not inextricably associated with the land.

* Because cost-segregation studies often misclassify or overlook land improvements, taxpayers should keep documentation identifying and segregating depreciable land improvements.

* Tax advisers can review prior-year returns and documentation to determine if land improvements were correctly classified, and if bonus depreciation is available.

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Identifying depreciable land preparation costs can provide significant tax savings for clients.

This article discusses land improvements that may be depreciable, and how to take advantage of the available tax savings.

Tax advisers recognize the tax savings available from reclassifying building components as personal property with shorter useful lives than the building itself. Similar savings are also possible by identifying land costs that can be classified as depreciable property. However, the increased depreciation deductions available by classifying land preparation costs as land improvements or other depreciable property are often overlooked in cost-segregation studies. Even greater tax savings may be available by claiming bonus depreciation on pre-2005 land improvements: For every $1,000 classified as a land improvement, rather than land, taxpayers save $289 in taxes. (1)

Identifying and segregating the costs of land from those associated with depreciable improvements has often been controversial. This article analyzes land preparation costs and provides suggestions as to how taxpayers can increase the costs eligible for depreciation.

Land vs. Improvements

Land preparation costs can be classified as land, land improvements or as part of another depreciable asset. According to Regs. Sec. 1.167(a)-2, land, apart from improvements or other physical developments added to it, is not depreciable. Land improvements are generally considered 15-year recovery property and include parking lots, canals, fences, sidewalks and driveways. (2)

Distinguishing between land and improvements is not always clear. The question whether land preparation costs are more closely associated with the land or depreciable assets has been examined in various IRS rulings. If a cost is "inextricably associated with land," it increases the land's value and will continue to be useful when the property on it is replaced or rebuilt. The Service has repeatedly concluded that the costs of grading, excavating and removing earth in leveling land for general purposes is inextricably associated with the land. (3) The courts have upheld this view. In Eastwood Mall, Inc. (4) a district court ruled that reshaping and leveling mountainous land into a flat earthen plateau were permanent land improvements, because the costs would not have to be incurred again if the mall were replaced.

In contrast, if land preparation activities will be destroyed by putting property to a different use, the costs are not considered inextricably associated with the land and are depreciable improvements. For example, the clearing, grading, terracing and landscaping of a mobile home park were held to be depreciable improvements with a 15-year life, because any other use of the property would require reshaping of the land. (5)

Limited Life

To be deemed depreciable improvements, land preparation costs must have a limited life. According to the IRS and courts, this is found when the improvements:

* Will be abandoned at the end of the useful life of a related depreciable asset;

* Will be physically destroyed or rebuilt when a related depreciable asset is replaced or retired; or

* Are subject to wear, tear or exhaustion.

Abandonment of related property: Land preparation costs may derive their useful life from a closely related depreciable asset if abandoning the asset will result in abandoning the land preparations. For example, the Service allowed (6) a taxpayer constructing a processing and storage complex to depreciate land grading and removal of soil to construct roadways. The taxpayer required a level system of roadways and buildings to use its transport vehicles properly. The roadways were considered inextricably associated with the buildings, because they would be abandoned when the buildings were abandoned. In Rudolph Investment Corp., (7) the Tax Court determined that roads on a ranch, which were constructed to reach depreciable improvements, had the same life as the improvements, because abandoning the improvements would also lead to abandoning the roads.

Contemporaneous abandonment has also been the basis for courts deciding that the costs of clearing and grading land to construct electric transmission lines are depreciable as utility proper. (8) An electric utility was allowed depreciation on costs to construct a reservoir that would be retired along with an electric generating plant. (9) In all of these situations, the land preparation activities would cease to be useful when the related depreciable property was abandoned.

Destruction of related property: If land preparation activities will be destroyed due to the replacement of a depreciable asset, then the costs have the same life as the depreciable asset. This "contemporaneous replacement requirement" is illustrated by golf courses. Resurfacing and molding land to construct a golf course with natural soil greens is not depreciable, because the courses are deemed to have an indefinite life. (10) Modern greens construction, however, starts with the initial shaping of the land, but also includes a network of subsurface drainage tiles, one or more layers of gravel and sand, a root-zone layer and a variety of tuff grass. Modern greens lose their effectiveness as the drainage system deteriorates, typically in 20 years. Because replacement of the drainage system requires physically destroying the greens, land preparation costs incurred in building modern golf course greens have the same life as their underlying drainage systems and, thus, are depreciable land improvements. (11) General grading costs related to the fairways, not the modern greens, are still capitalized as part of the land.

The contemporaneous-replacement approach is also allowed in building construction. Although general land clearing and grading costs are considered part of the land, land removal and excavation costs to construct spaces for building foundations, utilities and drainage systems are included in the building's basis. (12)

Wear, tear and exhaustion: Some types of land improvements are subject to wear and tear due to their nature, such as earthen dams, terracing, drainage ditches, canals and lagoons. (13) However, obtaining a depreciation deduction for these costs requires establishing that the improvements have a limited useful life. According to Kegs. Sec. 1.167(a)-1(b), the useful life of an asset is the period over which it may reasonably be expected to be useful in the taxpayer's trade or business. Before the accelerated cost recovery system (ACRS), taxpayers had to determine the length of the useful life to claim depreciation; if the useful life was indeterminate, depreciation was disallowed. For example, in Wolfsen Land and Cattle Co., (14) the taxpayer was not allowed to depreciate an earthen irrigation system for this reason.

The Service considered the useful-life requirement in Rev. Rul. 88-99, (15) which examined whether two different logging roads were depreciable. One road was supposed to be used indefinitely, but would require resurfacing every seven years. The IRS ruled that the roadbed did not have a determinable life, so it was not depreciable. However, it allowed depreciation of the road surface. The taxpayer also constructed a second logging road to be used exclusively for harvesting a certain area of timber, after which the road would be abandoned. It was estimated that the timber harvest would be completed in four years. The Service permitted depreciation of the costs to clear the land and grade the second road, because it had a determinable life.

The IRS and Tax Court disagree as to whether taxpayers must determine an asset's useful life to depreciate it under ACRS (and modified ACRS (MACRS)). Sec. 167(a) authorizes a depreciation deduction for property used in a trade or business or held for the production of income that is subject to exhaustion, wear and tear. The Tax Court has stated that taxpayers need not establish the property's useful life; this view has been upheld by the Second and Third Circuits in two cases involving musical instruments. (16) However, the Service did not acquiesce in these decisions. (17)

These cases apply to land preparation costs, because their useful life is often difficult to determine. If taxpayers fail to establish the useful life of such costs, the Service may disallow depreciation, as in Rev. Rul. 88-99. This issue has not reached the other circuits, so that taxpayers residing outside the Second and Third Circuits should be prepared to litigate if they depreciate assets with an indeterminable life.

The IRS subsequently applied its determinable-life requirement and concluded that the land preparation costs incurred in building roads and trails at a ski resort would benefit other facilities after the resort was retired or abandoned. (18) Because the taxpayer had not established a determinable life for the roads and trails, depreciation was not allowable. However, the Service permitted the taxpayer to depreciate the road surface, because it required periodic replacement.

In summary, to depreciate land preparation costs, taxpayers must demonstrate that the improvements are not inextricably associated with the land. They must also establish a limited life for the preparation costs, either by their relationship to a related asset or because the improvements themselves are subject to wear, tear or exhaustion. Whenever possible, taxpayers should determine the improvement's useful life.

Tax Planning 

The IRS uses a facts-and-circumstances test to determine whether land preparation costs are depreciable. Taxpayers should be prepared to demonstrate that land preparation expenditures meet the requirements described above. Documentation identifying and segregating depreciable land improvements can be provided by engineers, construction contractors, architects, appraisers and project accountants. Failure to provide satisfactory evidence of cost allocation has resulted in adverse rulings. (19) Cost information is best gathered as early as possible during the project's construction, rather than after the fact. The uniform capitalization rules (Sec. 263A) require taxpayers to capitalize direct and indirect costs properly allocable to the production of real and tangible personal property; proper identification of the indirect costs may increase depreciable basis. CPAs should work closely with engineers and contractors to develop this documentation.

Bonus Depreciation

Bonus depreciation offers an even greater tax savings from identifying land improvements. Under Sec. 168(k) (2)(A), tangible property with a MACRS recovery period of 20 years or less is eligible for bonus depreciation if placed in service before 2005. Bonus depreciation is 30% of the adjusted basis of qualified property acquired after Sept. 10, 2001 and before May 5, 2003, and 50% of the adjusted basis for property acquired after May 5, 2003 but before 2005.

To qualify for bonus depreciation, the original use of the property must commence with the taxpayer. Under Temp. Regs. Sec. 1.168(k)-1T(b)(3) (i), capital expenditures incurred to recondition or rebuild property can meet the original-use requirement, even if the underlying property is not qualified. Thus, road surfacing costs and other capital expenditures related to land improvements are eligible for bonus depreciation.

Example 1: Y purchased a beach resort as part of its business expansion. The resort was built 10 years ago and has been operating since then. Y resurfaced the resort's roads, parking lots, jogging trails and cart paths. The resurfacing is a capitalized land improvement eligible for bonus depreciation if the improvements were made before 2005.

Taxpayers that construct qualified property for their own use are eligible for bonus depreciation, as long as construction began after Sept. 10, 2001 (30% bonus), or after May 5, 2003 and before 2005 (50% bonus). Under Temp. Regs. Sec. 1.168(k)-1T(b)(4) (iii)(B), construction begins when physical work of a significant nature begins. "Physical work" does not include preliminary activities such as planning, designing, researching or securing financing, but is determined by the facts and circumstances. Temp. Regs. Sec. 1.168(k)-1T(b)(4)(iii)(B) provides a safe harbor that physical work of a significant nature begins when more than 10% of the property's total cost, excluding land and preliminary activities, has been paid or incurred.

Example 2: Z purchased land costing $10 million on which to build a golf course. The greens will have underlying drainage and irrigation systems. During 2004, Z paid the contractor $800,000 for general land clearing, grading and filling. He also incurred $500,000 in land preparation costs for modern greens. Z adds the $800,000 to the $10 million basis of the land. He treats $500,000 as part of the cost of the greens, which is eligible for bonus depreciation.

Depreciable land improvements received in a like-kind exchange or as part of an involuntary conversion are eligible for bonus depreciation under Temp. Kegs. Sec. 1.168(k)-1T(f)(5) (iii). To take advantage of this, taxpayers should determine whether any of the land received is properly classified as land improvements and calculate the amount of basis allocable.

Prior-Year Returns

Tax advisers should review clients' prior-year returns to determine whether depreciable land improvements were correctly classified and whether the taxpayer elected not to claim bonus depreciation. Taxpayers can still elect bonus depreciation for property placed in service after Sept. 10, 2001, as long as they did not previously elect out of bonus depreciation for the same class of property. Taxpayers who elected out and now want to change must apply for IRS permission by filing a letter ruling request. (20) Taxpayers that did not deduct bonus depreciation for the year the asset was placed in service may claim it by amending prior-year returns or filing Form 3115, Application for Change in Accounting Method. (21) Under Temp. Kegs. Sec. 1.168(k)-1T(e)(5), taxpayers must reduce the property's basis by the amount of the bonus first-year depreciation, even if they did not claim it.

Example 3: In 2002, H placed $30,000 of property in service that was eligible for bonus depreciation. She filed her 2002 return, but did not deduct bonus depredation. She also failed to attach a statement indicating that she was electing out. As a result, H must reduce her basis in the property by $9,000, the applicable bonus depreciation, even though she did not claim the deduction. H may claim the missed deduction by filing an amended return or Form 3115.

Taxpayers that exchanged property under Sec. 1031 and presumed that no bonus depreciation was allowed on the carryover portion of the new property's basis can also amend a prior-year return or request a change in accounting method to claim additional first-year depreciation.

Conclusion

Tax advisers should review prior-year returns of clients that constructed buildings or own farms, ranches, resorts, golf courses or other land on which depreciable improvements were made, to determine whether all allowable depreciation was claimed. They may also consider advising clients of the potential tax savings on land improvements placed in service by the end of 2004. When conducting cost-segregation studies, land accounts should be reviewed to ascertain whether previously capitalized amounts are eligible for depreciation. Clients involved in building projects need to understand the importance of appropriately documenting and classifying land preparation costs.

For more information about this article, contact Dr. Kelley at [e-mail] or Dr. Anderson at [e-mail].

(1) This is the present value of the tax savings due to depreciation over 16 years, assuming a 35% Federal tax rate and a 5% discount rate.

(2) See Rev. Proc. 87-56, 1987-2 CB 674.

(3) See Rev. Rul. 65-265, 1965-2 CB 52, clarified by Rev. Rul. 68-193, 1968-1 CB 79; and Rev. Rul. 8093, 1980-1 CB 50; but see IRS Letter Ruling (TAM) 200043016 (10/30/00).

(4) Eastwood Mall, Inc., ND OH, 4/14/95; see also Aurora Village Shopping Center, Inc., TC Memo 1970-39.

(5) See Trailmont Park, Inc., TC Memo 1971-212.

(6) See Rev. Ruls. 65-265 and 68-193, note 3 supra.

(7) Rudolph Investment Corp., TC Memo 1972-129.

(8) See Southern Natural Gas Co., 412 F2d 1222 (Ct. Cl. 1969); Commonwealth Natural Gas Corp., 395 F2d 493 (4th Cir. 1968); and Consumers Power Co., 299 FSupp 1180 (DC MI 1969), aff'd in part and rev'd in part on other issues, 427 F2d 78 (6th Cir. 1970).

(9) See Rev. Rul. 72-96, 1972-1 CB 67.

(10) See Edinboro Co., 224 FSupp 301 (WD PA 1963), and Rev. Rul. 55-290, 1955-1 CB 320.

(11) See Rev. Rul. 2001-60, 2001-2 CB 587.

(12) See Eastwood Mall, note 4 supra; Rev. Rul. 80-93, note 3 supra; and Rev. Rul. 74-265, 1974-1 CB 56.

(13) See Rudolph Investment Corp., note 7 supra; and James M. Tunnell, Jr., 512 F2d 1192 (3d Cir. 1975).

(14) Wolfsen Land and Cattle Co., 72 TC 1 (1979).

(15) Rev. Rul. 88-99, 1988-2 CB 33.

(16) See Richard Simon, 68 F3d 41 (2d Cir. 1995), aff'g 103 TC 247 (1994); and Brian Liddle, 65 F3d 329 (3d Cir. 1995), aff'g 103 TC 285 (1994); see also Brace Selig, TC Memo 1995-519.

(17) See AOD/CC-1996-009 (7/15/96).

(18) See IRS Letter Ruling (FSA) 200021013 (5/26/00).

(19) See e.g., Aurora Village Shopping Center, note 4 supra, and Algernon Blair, Inc., 29 TC 1205 (1958).

(20) See Rev. Proc. 2002-33, 2002-1 CB 963.

(21) See Rev. Procs. 2002-9, 2002-1 CB 327, and 2004-11, IRB 2004-3, 311, Section 3.01(1).

Claudia L. Kelley, Ph.D., CPA 

Associate Professor

Walker College of Business

Appalachian State University 

Boone, NC

Susan E. Anderson, Ph.D., CPA

Associate Professor

Walker College of Business

Appalachian State University

Boone, NC